CHAPTER 25 EXECUTIVE PERFORMANCE MEASURES AND COMPENSATION LEARNING OBJECTIVES: After studying this chapter, you should be able to... ab Enumerate the objectives of management compensation. _ Understand cash and noncash compensation. . Explain the three aspects of a bonus plan: the base for determining compensation, the compensation pool from which the bonus is funded, and the bonus payment options. So he ote ho ae he dhe he ateCHAPTER 25 EXECUTIVE PERFORMANCE MEASURES AND COMPENSATION Recruiting, motivating, rewarding and retaining effective managers are critical to the success of all firms. An important and integral Part of the determination of a strategic competitive advantage of a firm is an effective management compensation plan, Objectives of Management Compensation The firmn’s key objective is to develop management compensation plans that support its strategic objectives, as set forth by management and the owners. The objectives of management compensation are therefore consistent with the three objectives of management control: 1. To motivate managers to exert a high level of effort to achieve the goals set by top management. 2. To provide the incentive for managers, acting autonomously, to make decisions consistent with the goals set by top management. 3. To determine fairly the rewards earned by managers for their effort and skill and the effectiveness of their decision making. Executive Performance Measures and Compensation Studies. show that division manager’s compensation arrangements include a mix of salary, bonuses and long-term compensation tied to earnings and stock price of the company such as stock options and noncash compensation. ‘The goal of such compensation arrangements is to balance division and company wide incentives, as well as short-term and long-term incentives. One survey of companies reported the average annual incentive component of compensation as follows: (1) Average annual cash and, stock compensation based on long-run performance equal to 57% of current salary, and (2) Bonuses based on short-run performance equal to 40% of current salary.1014 Chapter 25 _ These percentages vary widely over the sample; some firms use stronger performance incentives than others. Cash Compensation Cash compensation includes salaries and bonuses, A company may reward good managerial performance by granting periodic raises. Salary raises, once affected, are however usually permanent while bonuses give a company more flexibility. Many companies use a combination of salary and bonus to reward performance by keeping salaries fairly level and allowing bonuses to fluctuate” with reported income. Of course, income-based compensation can encourage dysfunctional behavior such as the manager may engage in unethical practices like (1) Postponing needed maintenance, or (2) Postponing revenue recognition at the end of the year in which maximum bonus has already been achieved to the next year. Noncash Compensation Noncash compensation is also important. Some managers may trade off increases in salary for improvement in ttle, office location and trappings, use of expense accounts or use of “corporate country club facilities and so forth. Autonomy in the conduct of their daily business can also make the manager efficient and an important perquisite (a type of fringe benefit over and above salary). Stock options which give executives the ri specified price-(usually lower than market pri often used to motivate executives to i ight to buy company stock at a ice) within a specified period, are improve the company” performance to increase the stock price. Pany’s long-run Designers of executive or managers compensat; . sat ; factors: : sompensation plans emphasize three (1) achievement of organization goals, (2) ease of administering the plans, and (3) ensuring that affected executives perceive the pl. lan.__Executive Performance Measures and Compensation 1015 Bonus Plans As stated earlier, bonus compensa compensation and often the lar be categorized according to the Un ion is the fastest growing, clement of total part. A wide variety of bonus pay plans can key aspy of the compensation, that is, how the bo ‘The three most common bases are (1) stock p © The bas 15 pay is determined. ¢, (2) cost, revenue, profit, or investment unit-based performance, and (3) the balanced scorecard, * Compensation pools, that is, the source from which the bonus pay is funded. ‘The two most common compensation pools are earnings in the manager's own unit and a firmwide pool based on the firm’s total earnings. . Payment options, that is, how the bonus is to be awarded. The two common options are cash and stock (typically ordinary shares). The cash or stock can either be awarded currently or deferred to future years. Stock can either be awarded directly or granted in the form of stock options. Bases for Bonus Compensation The choice of a base comes from.a consideration of the compensation objectives, as outlined in Figure 25.1. Figure 25.1. Advantages and Disadvantages of Different Bonus Compensation Bases Relative to Compensation Objectives Motivation Right Decision Faimoss Stock pri¢e (#/-) Depends on (#) Consistent with La : whether sock and slock shareholders’ iterests, °°" of conrallabty coplions are included in base pay and bonus (+) aligns managomont ‘compensation with shareholder interésts1016 Chapte (+) intuitive, clear, and Strategic (+) Strongly motivating if (+) Generally a good why understood performance noncontrollable factors measure of economic aie erent sy measures are excluded performance erences a (cost, revenue, . () Typical hes ony Oe ventions, profit, and short-term focus aa aeet allocation methods, investment (-)f bonus is very high, 4 unis) tweates an incentive for financing methods, and inaccurate reporting so on. Balanced (+) Strongly motivating if (+) Consistent with (Ait ial scorecard noncontolable factors management's strategy and measurot, c® (ctitical are excluded ()Canbe subjectto _suocess facors ae success (+) aligns management inaccurate reporting of |__likely to be P factors) compensation with nonfinancial factors, ae shareholder interests measurement issues, aS - above Key: (+) means the base has a positive effect on the objective. (-) means the base has a negative effect on the objective. Bonus Compensation Pools A unit-based pool is a basis for determining a bonus according to the performance of the manager’s unit. A firmwide pool is a basis for determining the bonus available to all managers through an amount set aside for this purpose. Figure 25.2 summarizes the advantages and disadvanta; es of bonus pools. 'ges of each approach to Figure 25.2. Advantages and Disadvantages of Dj Relative to Compensation Objectives Bes of Different Bonus Pools Motivation Right Decision — Unitbased (Song motion or") Proves he : an effecti a " eee MATE iene eae et septate 7 anay ince of )U 218 not to e eee for Cooperate with and Bott ‘om the manager's economically weaker SePPOtt ther units when mance. units led for ded for the the frm,” 2 900d ofecutive Perfi me ive Performance Measures and Cy pensation 1017 Firmwide (+) Helps to attr attract and e retain goon alan (+) Effort for the good of (+) Separates the theengond man 9 the overall firm is Performance of the throug ut the firm, fewarded motivates manager from that of the in @conomically teamwork and sharing of — unit ON asses among units (+) Can appear to be Yotas strongly fairer to shareholders Motivating as the unit. and others who are based pool concerned that executive pay is too high Key: (+) means the Pool has a positive effect on the objective. () means the poo! has a negative effect on the objective, Bonus Payment Options The four most common Payment options are: Current bonus (cash and/or stock) based on current (usually annual) performance, the most common bonus form. Deferred bonus (cash and/or stock) earned currently but not paid for two or more years. Deferred plans are used to avoid or delay taxes or to affect the manager’s future total income stream in some desired way. This type of plan can also be used to retain key managers because the deferred compensation is paid only if the : manager stays with the firm. Stock options confer the right to purchase stock at some future date at a predetermined price. They are used to motivate ‘managers to increase stock a for the benefit of the shareholders. When exercised, stock options also have the positive effect of increasing the executive’s ownership in the firm, : ere by further increasing the executive’s alignment with shareholder interests. or this eason, ae firms require executives to own a significant amount of stock in the reason, company. ievi i als over hieving certain performance go: rant stock for acl Performance shares g! two years or more. 7 ° plans are shown in Figure 25.3. The advantages and disadvantages of the four1018 Chapter 25 Figure 25.3. Advantages and Disadvantages of Bonus Payment Options Relative to Compensation Objectives Motivation Right Decision Faimess: Current bonus (+) Strong motivation for _(-) Short-term focus + (+) Depends on the Current performance; _(-) Risk-averse manager clarity of thie bonus stronger motivation than avoids risky but arrangement and the for deferred plans potentially beneficial consistency with which it projects is applied Deferred bonus (+) Strong motivation for Same as for current Same as for current current performance, but bonus bonus nat as strong as for the * current bonus plan since the reward is delayed Stock options (+) Unlimited upside _ (+) Incentive to consider _(-) Uncontrollable factors potential is highly” —_onger-term issues affect stock price motivating (+) Provides better risk Also, same as for () Delay and uncertainty, incentives than for current bonus in reward reduces current or deferred motivation bonus plans: (4) Consistent with shareholder interests Performance Same as for stock (+) Incentive to consider (++) Depends on the shares options iongeterm factors that clarity ofthe bonus | affect stock price arrangements and the (#) Consistent with the consistency with which it firm's strategy, when is applied | ciitcal success factors are used (#) Consistent with shareholder interests when earnings per share is used Key: (+) means the payment option has a positive effect. (means the payment option has anegative effect.formance Z re! ~ mance Measures and Compensation 1919 Performance Measure; 's at the Individual Activity Level When evaluating performance indivi hen evalu: ating performance at the individual activity level two issues are involved: First: Designing performance Measures of activities that require multiple tasks, and Second: Designing performance measures for activities done in teams. Performing Tasks It is a common business practice that employers want their employees to allocate their time and effort intelligently among the various tasks or aspects of their jobs, For example, marketing representative sell products, provide customer support and gather market information. Production works are responsible for both the quantity and quality of their output. The performance measurement should measure the different aspects of an employee's job and to balance incentives so that all aspects are properly emphasized. Team-based Compensation Arrangements Pooling of talents of employees with multiple skills, knowledge, experiences and judgments can resolve many businesses problems, be they manufacturing, marketing and design-related. A team accomplishes better securities than individual employees acting alone. Business establishments reward individuals or a team on’the basis of team performance such as achieving regional sales target by the regional team. Such team-based incentives encourage individuals to help one another as they strive toward a common goal. To ener development of team skills, some companies use a checklist of team skills, sucl , inication and willingness to help. The desirability of team-base er depends, to a great extent, on the culture and management style of a particu aeaeaicatin Some criticisms on team-based compensation are a parti : i jiminished, harmin; (1) Incentives for individual employees to excel are diminishes 2 ind overall performance, al members who are not productive Se to the iam) 0 ee enovertheless share in the team’s rewards thereby dampening cess Ni a aie and morale of the good performer1020 Chapter 25 Team-based incentive compensation encourages employees to work together to achieve common goals. Individual-based incentive compensation rewards employees for their own performance, consistent with responsibility accounting, A mix of both types of incentives encourages employees to maximize their own performance while working together in the best interest of the company as @ whole. Environmental and Ethical Responsibilities As companies try to achieve the performance goals of their organizations, managers should be aware constantly of their environmental and ethical responsibilities. Illegal practices (such as bribery and corruption) and environmental pollutions (such as water and air pollution) carry heavy fines and are prison offense under the laws of many countries. Business ethics present difficulties in a single-country context, but they pose more problems in a global context. Ethical behavior on-the part of managers is paramount. They should not be tainted by “creative accounting” resulting to overstatement of assets, understatement of liabilities, fictitious revenues and understatement of costs.” Additionally, management should promptly and severely reprimand unethical conduct irrespective of the benefits that might accrue to the company from such action. A strong underlying system is important for enforcing contracts and provides the basis for confidence in ethical dealings. Other ethical problems with bribes and differing busifess laws exist. US companies that contract with overseas firms may find themselves the target of unfavorable publicity on use of child labor. The stories of bribery of Middle Eastern officials are legendary. In some countries! these bribes are a necessary part of doing business. Insider trading is not against the law in Europe and it is definitely illegal in the US. Socially responsible companies set very strict environmen and report their performance against them. For canal ae eee environmental performance a line item on every employee's sal pany makes report. Another company appraises employees on their part in pat appraisal waste, outing emissions and discharges and implementin cing solid problems. : ig environmentalCHAPTER MANAGING ACCOUNTING IN A CHANGING ENVIRONMENT LEARNING OBJECTIVES: After studying this chapter, you should be able to... 1. Define quality and total quality management 2. Understand cash and noncash compensation. 3. Explain the three aspects of a bonus plan: the base for determining compensation, the compensation pool from which the bonus is funded, and the bonus payment options. Po oho ote ake oke dhe oho eho afo efeCHAPTER 26 MANAGING ACCOUNTING IN A CHANGING ENVIRONMENT The business sections of bookstores contain a variety of works describing how to make organizations function better. They speak in terms of Benchmarking, Empowerment, Total Quality Management (TQM), Reengineering, Just-in-Time (JIT), Downsizing, Theory of Constraints (TOC), and Corporate Culture Most of these prescriptions are not di internal accounting systems organizational cl ted specifically at improving firms’ However, if implemented, most of these Jhanges require significant changes in the accounting system because the accounting system is an integral part of most firms’ organizational architecture. This Chapter expands on the framework first introduced in Chapter 2. Integrative Framework Previous chapters of this book described and analyzed management accounting systems. Besides being used for both decision making and control, these accounting systems support extemal reporting for shareholders, taxes, and government regulations. Thus, one of the central themes of this text is that trade- offs arise when the accounting system is designed for multiple purposes. In addition to providing a better understanding of the internal uses of accounting system, this book reinforces the importance of viewing the accounting system as part of the firm's organizational architecture. This analytic structure will help Teaders better understand, use, and design future accounting systems as well as other systems that evaluate and reward performance and partition decision rights. This final chapter summarizes the text and applies the analysis in the previous chapters to some recent internal accounting system innovations such as TQM, JIT, Reengineering, and TOC. Figure 26.1 expands Chapter 1's integrative framework for understanding how the accounting system is used in the firm’s organizational architecture. Startin; at the top, two external factors (technological innovation and market conditions)1030 Chapter 26 interacts with the affect the firm’s business strategy. The business see eae penseest firm’s organizational architecture to provide ca which in turn affect the employees. These incentives affect the actions taken aaa external factors like value of the firm. Thus, Figure 26.1 emphasizes etvsational architecture, technology and market conditions affect investments, org: incentives, actions, and ultimately the value of the firm. Figure 26.1. The determinants of business strategy, architecture, and firm value Technological Market litions innovation cond a 1 Business strategy Asset structure Customer base Nature of knowledge creation - Organizational architecture “Decision rights Partitioning Centralization/decentralization Performance evaluation ‘system Accounting system Nonfinancial systems Performance reward and Compensation Policy Promotion policy Separation of decision management from decision contro} Punishment System SS Incentives and actions Firm value organizationalManaging Accounting ina Changing Environment _ 1031 Figure 26.1 provides two important observations: 1. Changes in the accounting system rarely occur in a vacuum. Accounting system changes generally occur at the same time as changes in the firm's business strategy and other organizational changes, particularly with regard to the partitioning of decision rights and the performance evaluation and reward systems. 2. Alterations in the firm’s organizational architecture, including changes in the accounting system, are likely to occur in response to changes in the firm’s business strategy caused by external shocks from technology and shifting market conditions. Three significant managerial implications are derived from these two observations. First, before implementing an accounting or other organizational change, it is important to understand what is driving the change. Second, an accounting system should not be adopted merely because other firms are doing so; they may be reacting to a different set of extemal shocks. Third, an accounting system should not be changed without concurrent, consistent changes in the way decision rights are partitioned as well as in the performance reward systems. All three parts of the organization's architecture must be internally consistent and coordinated. Organizational Innovations and Management Accounting ‘A number, of organizational innovations have been proposed. Total Quality Management, Just-in-Time Production Systems, Reengineering, Theory of Constraints, Productivity Measures and Activity-Based Costing and so forth. This section describes these innovations and their effect on management accounting and then illustrates how to apply them to better understand the innovations in terms of what is causing firms to adopt them and whether they will be suctessful. The other innovations not discussed in’ this Chapter such as Productivity Measures, Activity-Based Costing are presented in the earlier chapters. TOTAL QUALITY MANAGEMENT . What is Quality? Although people often view quality differently because of differences~in their roles in the production-marketing-consumption chain and their expectations For1032 Chapter 26 the production or services, the ultimate test of a quality product or service 1s whether the product or service meets or exceeds customers’ expectation. The requirement to meet or exceed customers’ expectations then roa fl specifications for operations throughout the organization. Each indivi a department or subdivision throughout .an organization needs to strive for conformity to specifications that meet and improve upon customer satisfaction. As aptly described by Procter and Gamble, “Total quality (management) is the unyielding and continually improving effort by everyone in an organization to understand, meet and exceed the expectation of customers.” This description of TQM points out that the core principles of TQM are processes that Focus on satisfying the customer Strive for continuous improvement Involve fully the entire work force Support and involve top management actively Use clear and measurable objective Recognize quality achievements in a timely manner Provide training on TQM continuously Focus on the Customer TQM begins by identifying the firm’s customers, external and internal; determining their needs, requirements, and expectations; and then doing whatever it takes to satisfy them. External customers are the ultimate recipients of the firm’s products or services. Internal customers are individuals or subunits within the firm involved in manufacturing the product or providing the services At some stage, everyone in a processor organization isa customer or supple c someone else, either inside or outside the organization. : These requirements and expectations become the bases internal customer/suppliers and external suppliers to the translated into specifications for each successive internal customer/suppli including design requirements, part characteristics, and. mann guPPlien operations, and requirements for external vendors. A finra can sere nt factuting . ‘an serve its ultims external customer better if the firm fully meet : S ultimate, s all re : > aes 'y ‘quirements of each internal for specifications for firm. They are then_ Managing / Managing Accounting ina Changing Environment 1033 Strive, i? ‘for Continuous Improvement (Kaizen) The Coca-cola Ci ‘ompany believ: at Coa eee that quality is not a destination; it is a way of Coca Y states: “We know we will never arrive; there is no finish.” Quality i i inish. is a moving targ : disappears. @ target. Without continuous improvement, quality Taguchi and Wu beli 7 i (kaizen) are eee quality improvement and cost reduction “With competitors forever main competitive in today’s global marketplace. changing expectati ver trying to outperform us and customers exhibiting ever- Saree a ae a firm can never reach the ideal quality standard.” Firms ee ously update specifications for both internal customers/suppliers external suppliers to better serve external customers. Full Involvement of the Entire Workforce The requirement of the firm’s external customers can only be met if each of the internal customers/suppliers in the process satisfies the requirements of the downstream process or customer. Any breakdown in the process no matter how insignificant can lead to a defective product or service and unsatisfied customers. Top management must encourage everyone in the firm, from the lowest level employees, office clerks, factory workers, accountants, and engineers to upper echelon professionals and managers, 10 be actively involved and to participate in the firm’s efforts to continuously improve quality. Employee involvement can range from simple ‘information sharing, dialogue, or group problem solving, all the way to total self-direction. One proven effective approach for employee involvement is quality control) circles oF gulity circles (QCS for short). A eoevroleris a small group of employees from the same work area that meets quality cirere ti 4 problems and to implement and reguiarly to ident! ify and solve work-relate monitor-solutions to the problems. Active Support and Involvement of Top Management fal implementation of TQM requires i . However, ship from the CEO and senior manaeet . a alone cannot bring forth all the desired benefits of ir TOM attain : atoll managers in the top echelon can T= TOM: One aay oa Feo, they need to demonstrate their Cae i the most desirable rr at every level al “vendors and suppliers to the firm, aff total quality t0 emPO PT ity at every ‘ypportunity so that everyone is ‘awart customers Wt ortance Of | quality in every aspect of the firm’s operations. the primary imp: Most compani und that success unwavering and active lea the CEO or top managemen'1034 Chapter 26 Use Clear and Measurable Objectives Progress can easily be seen if objectives are clear. Measurable objectives forge efforts toward the common goal. To ensure success of total quality management, a firm must set unambiguous and measurable objectives, Effective measurement can help to ensure and facilitate quality improvements and supporting systems. Timely Recognition of Quality Achievement Quality achievement of people and subunits when recognized timely is the best ‘Way to emphasize the firm’s continuous struggle for better quality and to ensure efforts toward total quality at every level. Efforts and progress will most likely be short-lived if the firm makes no change to its compensation / appraisal / recognition system. Continuing Education and Tr ‘raining Employee training programs serve as a communication link to convey mraraeement commitment to total quality and provide employees with necessary skills to achieve total quality. Mandatory continuing education and training of Employees at all levels is necessary to achiieve the culture change and continupus focus required in a TQM environment. TQM Implementation Guidelines A firm cannot implement a successful TQM program overnight any organization serious about achieving TQM several years o dedicated efforts by all its members to bi It usually takes f concerted and ecome a world-class quality firm. takes three to five years to make from traditional Although some specific projects can quickly yield high 1. likely not see many tangible benefits in the early years of management to TQM, eturns, a firm will most implementation, The Institute of Management Accountants (IMA) has Process spanning three years to establish TQM. It is reen genuine involvement of all employees must be present toi TOM. devised an 11-phase mmended that full and mplement successfullyManaging Accounting in a Changing Environment 1035 Year One ~ Preparation and Planning © Create quality council and staff © Conduct executive-quality training programs © Conduct quality audits * Prepare gap analysis (determine the gap between the best in class and the firm's current practice) Develop strategy on quality improvement Year-Two ~ Training and Implementation © Conduct employee communication and training program Establish quality teams Create a measurement system and set goals Year Three ~ Assessment, Review & Revise © Revise compensation / appraisal / recognition systems Launch external initiative with suppliers © Review and revise Types of Conformance Quality involves conformance with specifications for product or services that meet or exceed customer requirements and expectations. Conformance, however, can differ among individuals or firms. ‘The general types however are 1. Goalpost Conformance (zero-defects conformance) i ality specification expressed as a specified nse Secured ‘The age the ideal or desired outcome of the rare roe This is also called zero-defects conformance with the operation® age allowed for variations. Management expect all outputs specified range © cpecified range of variations. For example, a firm ee ce of + 0.05 inch thickness of its products with a target oro. it ess. Ths means that the firm meets the quality of standard of 0. : hen the result shows that the thickness of its products is between 0.55 when i inch and 0.45 inch. ity conformance (robust quality approach) . Absolute quali : ces to meet 2. Absol ance which requires that all products oF services fp mee This is one exactly with no variation. For en a oF 050 the target val sires that all sheet metal to have a thiekne conformanct ee1036 __ Chaprer 26 inch, nor $ inch or even + 0.0005 inch. Any variation from the target values is less than ideal and can have economic consequenc’S. Robustness in quality comes with meeting the exact target consistently. Any deviation from the target is a quality failure and weakness in the overall quality of the product or service. Generally, for firms desiring to gain long-term profitability and customer satisfaction, absolie Conformance ig considered a better approach that zero-defects conformance. Each business function examines its own activities and works to meet improvement goals. Accountants help operating managers understand how decisions in product design affect quality (and costs) in manufacturing distribution and customer service. One of the tools used is benchmarking which cnvelves. studying organizations that are among the best in the world at performing a particular task, Identification of quality-related costs is also necessary if TQM is to be applied Costs of Quality ‘Three factors underlie the quality of a product or service. These factors are grade, quality of design, and quality performance. The bulk of all quality costs are associated with quality of conformance and these costs can be broken down into four broad groups. 1. Prevention Costs ‘These are costs incurred to avoid poor-quality goods or services or educe the number of defects in products or services. These include Systems development Quality data gathering, analysis, Quality engineering and reporting . Quality raining” Quality improvement projects Quality circles Technical support provided to Statistical process control activities suppliers. Supervision of prevention activities Audits of the effectiveness of the quality system 2. Appraisal Costs These costs, also called inspection costs, are incurred to identify products before the products are shipped to customer se include = These Test and inspection of incoming Supervision of testing and materials inspection activitiesManaging Accounting in a Changing Environment 1037 Test and inspection of in-process Depreciation of test equipment goods Maintenance of test equipment Finished product testifig and Plant utilities in the inspection area inspection Field testing and appraisat at Supplies used in testing and customer site inspection 3. Internal Failure Costs These are costs that result from identification of defects during the appraisal process. Examples are Net cost of scrap Disposal of defective products Net cost of spoilage - Analysis of the cause of defects Rework labor and overhead in production Reinspection of reworked products _Re-entering data because of Retesting of reworked products keying errors Downtime caused by quality problems Debugging of software errors 4. External Failure Costs These are incurred when poor-quality goods or services are detected after delivery to customers. They include Cost of field servicing and handling _ Liability arising from defective complaints products : Warranty repairs and replacements Returns and allowances arising from Repairs and replacements beyond the quality problems warranty period Lost sales arising from a reputation Product recalls for poor quality Prevention and appraisal costs are costs of conformance because they are incurred to ensure that products and services meet customers’ expectations. Internal fajlure and external failure costs are costs of nonconformance because they are costs incurred and opportunity costs because of rejection of products or services, The cost of quality is the sum of. conformance and nonconformance costs. Prevention costs and appraisal costs are incurred in an effort to keep poor quality of conformance from occurring. The other two groups, known as internal failure costs and external failure costs, are incurred because poor quality fo ponforst has taken place. A company can reduce its total quality costs OY - efforts on prevention and appraisal. By this means, failures ie mi any defects are detected before delivery of products to customers.1038 — Chapter 26 It will be noted that quality costs do not just relate to manufacturing; rather they relate to all activities in a company from initial research and development through customer servicing. Therefore, as part of the quality cost system, companies must gather the quality costs from each activity and accumulate these costs on a quality cost report. This report then becomes the foundation of the quality cost system in that it will show management the type of quality costs being incurred, as well as the amount and trend of these costs. Uses of Quality Cost Information The quality cost information is used by managers in several ways. These are 1. Quality cost information provides a basis for establishing budgets for quality costs as management looks for ways to reduce the total cost involved. 2. Quality cost information helps managers see the financial significance of quality. 3. Quality cost information helps managers identify the relative importance of the quality problems faced by the firm. 4, Quality cost information helps managers see whether their quality costs are poorly distributed and when needed, it helps them distribute the costs better, Limitations of Quality Cost Information 1, Some important quality costs are typically omitted from the quality cost report. Examples are opportunity cost of lost sales, cost of top management time in designing and administering the quality program. 2. Simply measuring and reporting quality costs does not solve quality programs. Only management action can solve them. * 3. A log may exist between when quality improvement programs are put into effect and when the results are seen. Reporting Quality Costs The purpose of reporting quality costs is to make management aware of the magnitude of quality costs and to provide a baseline against which the impact of quality improvement activities could be measured. Tasks for reporting quality Costs include data definitions, identification of data sources, data collection, and Preparation and distribution of quality cost reports.Managing punting ina Changing Environment 1039 Mlustration of a Cost of Quality Report Figure 26.2 illustrates a cost of quality report. Bean Company is a small Midwestern manufacturing company with annual sales of around 9 million, The firm operates in a highly competitive environment and has been experiencing. increasing pressures to raise quality and lower cost from new and existing: competitors. The report shows that the external jure costs for such items as warranty claims, customer dissatisfaction, and market share loss accounted for 75 percent of the total cost of quality in year 0 (P1,770,000 + 2,360,000 or 22.13% + 29.5%). To be more competitive and to increase market shares, Bean began a corporatewide three-year TQM process. The firm started with substantial increases in prevention and appraisal expenditures. The investment started to pay off in year 2. The internal failure, external failure, and total quality costs have all decreased. Figure 26.2. Cost of Quality Report for Bean Company Percentof Percent Total “of Total Percent Year2 Sales Yearo Sales _ Change Prevention Costs Training P 90,000 P 20,000 350% Quality planning 86,000 20,000 30 Other quality improvement 60,000 40,000 50 ‘Supplier evaluation 40,000 30,000 23 Total P.276,000 3.07% 110,000 1.38% 151 yraisal Costs ‘Teng 120,000 100,000 2» Quality performance measurement 100,000 0,000 % Supplier monitoring 60,000 10,000 500 Customer service 30,000 40,000 200 Total 310,000 3.44% 700000 25% 55 |) Internal Fafiure Costs Rework and reject 55,000 150,000 (3) Reinspection and testing 35,000 30,000 16 Equipment failure 30,000 50,000 (40) Downtime — 20,000 50,000 (60) Total Fi4o00 1.56% 7700000 35% «=, (60) External Failure Costs 7 Produ iabilty insurance 70,000 250,000 2) Warranty repaits 400,000 sine 600,000 1,400,006 Ace eee 77000 «= 8.58% © PA770000 22.13% 8) Total quality costs 1,496,000 16.62% 22,360,000 29.50% 7) Total Sales 9,000,000 100% 8,000,000 100% _1040 Chapter 26 - a finan Satisfaction Nonfinancial Measures of Quality and Customer Sati sf fon how well their actual performance satisfies customer needs and en supplement.financial measures with nonfinancial Measures of quality ‘of design and conformance quality. Nonfinancial scife area ca the future needs and preferences of customers, as well as ee rated a need improvement. In. this sense, nonfinancial measures of quality e. lea ing indicators of future long-run performance, unlike financial measures 0 quality that focus on the short run, Management accountants usually maintain and Present these nonfinancial measures, We focus first on tionfinancial measures of customer satisfaction, including nonfinancial measures of quality of design and external failure, and then we look at internal performance measures, including nonfinancial measures of prevention, appraisal, and internal failure. Nonfinancial Measures of Customer Satisfaction To evaluate how well they ai ; re doing, companies measure customer satisfaction Over time. Some measures are: - J. On-time delivery rate (the percenta, ¢ of shi scheduled delivery dag) 8° of shipments made on or before the 2. Delivery delays (the difference betw, ; the date requested by the customer) Ne Scheduled delivery date and 3. Percentage of products that fail soon or often tomer complaints (c, ( ‘OMpanie: it plains, there ate 10, estimate that for every the product of service but dig others who have had © units shipped 4 NOt complain, *S.4 percentage of total . 5. Ndimber of defectiy, units shipped 6. Market research satisfaction with g ° Customers information or . nc Pecific produg Ustomer Sf features Preferences ang customerManaging A nting in a Changing Environment _ 1041 Nonfinancial Measures of Internal Performance To satisfy their customers, managers must constantly improve the quality of work done inside their company. Most companies use nonfinancial measures of internal quality to supplement financial measures, such as prevention, appraisal, and internal failure costs. Examples of trends to gauge quality are: 1. Number of defects for each product line 2. Employee turnover (ratio of number of employees who leave the company to the average total number of employees) Process yield (ratio of good output to total output) Time as a Competitive Tool Many companies consider “time” as a driver of strategy. They need to measure time to manage it properly. Two common operational measures of time are customer-response time and on-time performance. Managing customer-response time and on-time performance requires understanding the causes and costs of delays. Delays can occur, for example, at a machine in manufacturing or at a check-out counter in a store. Customer-Response Time Customer-response time is the duration from the time a customer places an order for a product or service to the time the product or service is delivered to the customer. Fast responses to customers are of strategic importance in industries such as construction, banking, car rental, and fast food. Figure 26.3 describes thie components of customer-response time. Manufacturing lead time {also called manufacturing cycle time) is the duration between the time an order is received by Manufacturing to the time it become finished good. Manufacturing lead time is the sum of waiting bie an manufacturing time for an order. Delivery time is how long it takes to deliver a completed order to the customer. Several companies have adopted manufacturing lead time as the pase i ing, indi it ts to products. They believe that using indirect manufacturing costs t 9 sea Jead time as a cost allocation base motivates managers to eee a it takes to manufacture products. Over time, total overhead costs the “Iocrease and operating income rises.1042 Chapter 26 On-Time Performance 5 A + service On-time performance refers to situations in which the peer ane actually delivered by the time it was scheduled to be de eaten performance increases customer satisfaction. Commercial a ena passengers as a result of consistent on-time service. But there Deliberately between customer-response time and on-time performance. i ening scheduling longer customer-response times, such as airlines lengt ening scheduled: arrival times, makes achieving on-time performance easier — but it could displeasé customers! Figure 26.3. Components of Customer-Response Time Order Customer Order . manufactured: Order places order received by ~ Order product becomes delivered to for product manufacturing is setup finished good cisiomen Waiting Manufacturing ean Time Receipt Manufacturing Time Lead Time Customer-Response Time Illustrative Problem 26.1. Measurement of Quality Service The Sterling Moving Corporation transports household goods from one city to another “within the Luzon Area. It measures quality of service in terms of (a) time required to transport goods, (b) on-time delivery (within two days of agreed- upon delivery date), and (c) number of lost or damaged shipments. Sterling is considering investing in a new scheduling and tracking system costing P160,000 per year, which should help it improve performance with respect to items (b) and (c). The following information describes Sterling’s current performance and the expected performance if the new system is implemented: Current Expected Future Performance Performance ‘On-time delivery performance 33% one Variable cost per carton lost or damaged P60 Pee Fixed cost per carton lost or damaged Pao as Number of cartons lost or damaged per year 3,000 cartons 1,000 cartons —amainimmmmeiinaaataa ns aaa aeomaieniate eneatiaemantttiManaging Accounting in a Changing Environment 1043 Sterling expects each result in revenue incre; percentage is 45%, Percentage point increase in on-time performance will ases of P20,000 per year. Sterling’s contribution margin REQUIRED: 1. Should Sterling acquire the new system? Show your calculations. 2. a the minimum amount of revenue increase needed for the benefits rom the new system to equal the costs. Solution: 1. Additional Costs of the new scheduling and tracking system are P160,000 per year. Additional annual benefits of the new scheduling and tracking system are Additional annual revenues from a 10% improvement in on-time performance, from 85% to 95%, P20,000 per 1% x 10 percentage points 200,000 45% contribution margin from additional annual revenues (0.45 x P200,000) P 90,000 Decrease in costs per year from fewer cartons lost or damaged (only variable costs are relevant) [P60 per carton x (3,000 ~ 1,000) cartons} 120,000 P210,000 Total additional benefits Because, the expected benefits of P210,000 exceed the costs of P160,000, Sterling should invest in the new system. sag eams. a contribution margin of P40,000 (to cover 2, As Tong as Sterling. 160,000 minus relevant variablecost savings of incremental COSS onal annual sales, investing in the new system it es org contribution margin corresponds to additional sales of eneficial- 40,000 + 0.45 = P88,889-1044 Chapter 26 JUST-IN-TIME SYSTEM The initial discussion on Just-in-Time system is found in Chapter 2 Just-in-time (JIT) production, also called lean production, is demand ae manufacturing system because each component in a production line He aS Soon as and only when needed by the next step in the production fin ce Ina zy production line, manufacturing activity at any particular workstation is (oes by the need for that workstation’s output at the following, workstation. Demand triggers each step of the Production process, starting with customer demand for a finished product at the end of the Process and working all the way back to the demand for direct materials at the beginning of the process, In this way, demand pulls an order through the Production line. The demand-pull feature of JIT Production systems achieves close coordination among workstations. — [t smoothes the flow of goods, despite low quantities of inventory. JIT production systems aim to simultaneously (1) meet customer demand in a timely way, (2) With high-quality products and (3) at the lowest Possible total cost, Key Features The key features of a JIT production system are 1. Maintaining a limited number of suppliers A company must learn to rely on a few ultrareliable suy willing to make frequent deliveries in small lots, essential since companies are highly vulnerable to any Supply when JIT is in use. If a single part is un assembly operation may have to be shut down, Pliers who are Dependability is 'Y Interruption in available, the entire 2. bnproving plant layout factory to minimize handling and moving, can dramatically reduce throughput time which is the time required to make a produo + By doing so, the company (also known as cycle time)